How To Cool Down Markets with 78,960,000 Gallons of Oil (Per Day)

Over the last 18 months, a barrel of oil went from 110$ to 30$, which is almost a 75% discount on one of the most widely available commodities. Isn’t that insane? Of course, there’s overproduction on the market, but does it justify a 75% discount?

The Oil & Gas Industry, it’s no secret, is being hammered.

More than a quarter of a million jobs have been cut and stock prices have tumbled. Investment in the industry have been cut by an estimated 380 billion $ as everyone is refocusing on cutting costs in face of an ever lower market price for oil.

Walking A (Very) Fine Line

When I first heard that all this mayhem came from an imbalance between production and demand, I thought it made sense. After all, once the demand is covered, the additional production would go straight into storage. With enough time, all this storage will fill up and there would be less and less buyers interested in purchasing more the oil. If more of it came on the market, it would just sell at a discount.

But how much overproduction is there really? How much of a commodity would you need on a market to justify selling it for 25% of the cost from just 1 year ago?

the world consumes 3,990,000,000 gallons of oil every single day

According to the latest report from the IEA, the world consumption in Q4 2015 was 95 Million Barrels a day (mb/d). Knowing that a barrel is 42 gallons, the world is consuming 3,990,000,000 gallons of oil every single day!

Yes, we’ll need a lot more renewable energy to save ourselves from climate change. But I digress.

In the same report, the world production in the same period was 96.88 mb/d. A mere 1.88 mb/d or 78,960,000 extra gallons that would go straight to storage facilities. That is just a 2% overproduction!

The daily overproduction of oil in 2015 was just between 1% – 2% and the price tanked by more than 75%. The act of balancing the supply / demand for the oil markets is like walking a very fine line.

Competition Without Borders

What has surprised the market is that this imbalance has led to surreal levels of discount. Since the US became the #1 producer of oil in 2013 with the shale gas revolution, leading Saudi Arabia #2 and Russia #3, the global production increased much quicker than the global demand.

The imbalance started to become visible but the fracking frenzy was on and going strong.

Oil production by country

That’s when OPEC, led by Saudi Arabia, decided to ramp up its production and compete to regain market share and flood the market with more oil. Not any kind of oil though, but the cheapest oil in the world.

The idea would be that if enough cheap oil enters the market, it will drive the prices down and will gradually force the the more expensive players out of the market. And boy it did.

As prices went down, traders realized that OPEC was in it for the long run and no-one could compete. Prices went down and further down until they reached depressed levels of 30$ / barrel.

Historical Oil Prices

Even Saudi Aramco’s chairmain, M. Al-Falih, believes these prices are ‘irrational’, as the Financial Times reports from his Davos speech: “The market has overshot on the low side and it is inevitable that it will start turning up,” said Mr Al-Falih.

What is killing the price of oil is not overproduction, it’s FEAR.

What is killing the price of oil is not overproduction, it’s FEAR.

It’s the fear that OPEC is serious about keeping the production imbalanced for a long time. The fact that Saudi Arabia is one of the only countries who denied climate change and didn’t propose emission cuts at the Paris Climate Conference doesn’t help.

The market has now realized that oil at 100$ was an exception and that the 30-50$ range is the norm, as it has been for the last 30 years.

In fact, the futures contract for US Oil are trading between 35$ and 50$ for the next 10 years. Futures for December 2024 are trading at just 51$.

What Is Really Keeping Oil Prices Down?

The oil prices are now depressed, and will remain so, as long as the overproduction persists and remains in control of OPEC. This is likely to remain so in the short term, until either an agreement is reached for production cuts across the board, as Russia’s prime minister floated the idea today, or political tensions escalate in countries or between countries, to force an agreement.

But more importantly, as long as there is a high level of confidence in the market that prices can remain low, for a long time, oil will remain cheap. To understand for how long OPEC could sustain oil at 30$, The Economist has put together an interactive chart of the profitable reserves by country, depending on the cost of a barrel.

Oil reserves by Country, by Price

Under 40$ a barrel, OPEC control 80% of the profitable reserves in the world. If you want my opinion, that’s a pretty powerful amount of bargaining power.

Should You Buy Oil and Gas Stocks?

Stocks have fallen so much in the last 12 months that it is tempting to think they’ve reached a bottom. We could reasonably expect that the trends will eventually ‘revert to the mean’ and generate great returns for their investors who invest in the downturn.

What is very possible is that stocks have reverted to the mean already, but lower.

The industry in general is not expecting to come out of the bottom before end of 2017. I would expect the industry to come out of the crisis stronger, leaner, more efficient and more consolidated so there could be profits for the investors who plan on holding their stocks for 3-5 years. A shorter holding period would, in my opinion, be a risky move, but a longer period would likely be an advantage.

I currently hold and keep on contributing to my company’s stock through our Employee Discounted Stock Purchase Plan, but mainly because the discount mechanism allows me to invest at rock bottom levels.

Question: Do you believe Oil has reached a bottom already? Would you consider investing in energy stocks now, hoping that they will recover to healthier valuations in the future?

-Nick

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8 COMMENTS

I’m more inclined to think that oil hasn’t seen the bottom yet. Id love for it to keep climbing even back into the $40/bbl range, but I expect there is going to be some “crazier, more irrational” drop before it stabilizes. Seeing that Economist graph really drove home how much oil is uneconomic at $30 and $40/bbl. Th bigger thing is that while Saudi can produce it for profit at that price point, the social programs they have set up in their country rely heavily on closer to $90-$100/bbl costs. They had a ~$100 Billion shortfall on their budget this past year, so while they can make money, they’re structured like the typical American household and are spending more than they earn. That can’t be sustainable for too long, maybe 3-5 years, depending on their budget cuts, but then most of those programs are what keeps their citizens happy and their country stable. I’m more interested in how that will play out as a whole, than where oil price ends up, because those factors are tied together way more intimately with oil price in my mind.

And that is the end of my ramble about oil prices, but great post. I’m still investing in O&G stocks, but then it’s hard not to in my line of work. Like you pointed out, the industry may have reset to “normal” prices so there may not be huge growth, but I have faith that we’re not going to see everyone fail at $30/bbl, we’ll just see it reflected at the pump, grocery store, and retail because costs will have to get recouped somewhere.

You have a good point, many of these producing countries had their budget balanced at 100$/bbl. With revenues reduced by 70% or more, there will be more than just budget cuts. Saudi has raised several billions of debt recently on the market, so they can probably extend their social program a little. If oil remains low for too long, there will be growing social & political challenges, either domestic or international. There will likely be lots of failures for the smaller companies but I’m sure many assets will be scooped up by the bigger players. Like Kelly Clarkson says, What doesn’t kill you makes you stronger. Whichever company manages to go through the downturn will be a great shape (read: very lean) when prices normalize.

That’s a great chart that shows that oil probably won’t be returning to its glory days… and now Alaska will fall off the map! Just kidding. Nothing that dramatic, but we may be getting a state income tax. *GASP* 🙂

It is good to have this kind of background on the oil price. The comment from SSC puts some extra content on the impact that current prices have on the politics of these countries. For now, I stick to my rdsa and kmi stock. I also explore options on the sector as volatility us quite high at this time .

It will be interesting in 2016 to see how many of these countries that had budgets at 100$ a barrel manage to cut back on expenses and social programs. Saudi may have some room for maneuver, but the likes of Venezuela and Nigeria will feel it most. Playing the volatility on the sector must be an exciting game, this isn’t something that I could do, but if you’ve got some ideas I’d be curious to know how it works!

For me, it started with discovering options last year. I just happened to start with an oil stock. Later, after the KMI correction, I added this stock as well and started to write covered calls and puts against it. I have some blogposts on the topic of options, and some more coming. tastytrade is a great online news/educational network as well to get started.

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